What is FX trading?
What is FX trading and can you make money from it? Rupert Hargreaves explains how it works and the risks.
Foreign exchange trading, or FX trading, seems to be all the rage and a fast route to riches.
But the reality couldn’t be more different. In fact, most so-called retail traders (those of us without millions of pounds to play with) lose money FX trading.
What is FX trading?
FX trading is, in the simplest possible sense, the process of buying and selling different currencies in the hopes of making a profit.
The value of a currency against another is determined by a number of different factors.
A country's interest rates, economic position, and economic policies all help traders determine the value of a currency against its peers.
However, while these factors do influence the value of the currency over the long term, in the short term, and I’m talking about hours and days here, the value of a currency is determined by market sentiment and news headlines.
That’s what makes FX trading so challenging. The investment and trading environment can change in the blink of an eye causing potentially huge losses for traders.
Another reason why FX trading can be so risky is the fact that traders usually have to use leverage.
Traders often employ leverage to increase potential profits although this also increases potential losses.
But before I take a deeper look at the risks of borrowing money to trade a volatile asset class, I think I first need to take a step back and explain how currency markets work.
The ins and outs of trading currencies
If you’ve been on holiday, you will know the basics of the FX market. If you want to spend money in another country, you will have to change your funds from pounds sterling to whichever currency it is you want to spend.
If you go to a foreign exchange booth and change your pounds sterling for dollars, for example, you are effectively selling sterling to buy dollars – very similar to selling any other good or service.
If I have £100 and want to change it to dollars I can offer to sell it to a buyer who is willing to sell me a different currency in return.
This is how FX trading works on the global market, although on a much larger scale.
Every day $7.5trn of currencies are bought and sold around the world. From individuals transferring money to go on holiday or sending money home to relatives, to private equity companies forking out billions to acquire a business in a different country, the basics of the process are the same.
Foreign currency traders try to make money by buying a currency at one price and hoping to sell it back at a higher price.
For example, if I go on holiday to the US and want some spending money, I would sell my pounds sterling to buy US dollars. At an exchange rate of £1 to $1.20 I could buy $120 with a sum of £100.
If I don’t spend this money, I can change it back when I get home. But currency markets are constantly changing, and that’s where FX trading can be quite profitable.
If the exchange rate moves when I’m away, from $1.20 to $1.18, when I try and sell my dollars back in the UK, they will buy £101.70, a profit of £1.70.
FX trading can produce huge losses
On a day-to-day basis, the rate of exchange between one currency and another is nothing more than a reflection of market sentiment. As such, currencies can swing widely in value.
But over the long term exchange rates are determined by multiple macroeconomic factors such as interest rates, economic growth, and a country's debt load.
Foreign currency trading involves trying to capitalise on short-term market movements to make a profit and leverage is usually used to improve returns.
Going back to my holiday example; a profit of £1.70 is far from being enough to make a living. A more attractive profit might be more in the region of £1,700, but to earn this I’d have to have sold £100,000 in the first place.
That would be fine if I had the backing of one of the world's biggest banks, but for most, it’s an unattainable starting point.
That’s where leverage comes into play. FX trading platforms usually offer punters leverage to increase profits and losses.
One of the world’ largest trading platforms offers investors leverage of as much as 1:2000. That means for every £1 in an account a trader can play with £2,000 so I’d only need £50 to trade £100,000.
This is where things can get dangerous. While leverage makes it easier to make money, it also makes it easier to lose money.
Let's say I think the pound is going to fall in value against the dollar. To make money from this trade I would go “short” the pound against the dollar (GBP/USD).
If a trader goes “long” they’re hoping the price will rise. If a trader wants to bet against a currency they will “short” it.
If the exchange rate for the pound against the dollar is $1.20, and I want to go short sterling, I would purchase £1 for $1.20 in the hopes that the dollar appreciates. If it does, I can sell my dollars for pounds and earn a profit on the difference.
And by using leverage I can improve my returns.
So, if I use leverage of 1:2000 I can short the pound against the dollar using £100,000 (traded for $120,000) with a deposit of just £50.
However, if the value of the pound against the dollar rose rather than fell I’d have to deal with some steep losses.
If the exchange rate moved from $1.20 to $1.22 and I bought my pounds back, I would receive £98,361. That would be a loss of £1,639 not only wiping out my deposit but also leaving me £1,589 in debt.
Put another way, if a trade goes the wrong way, you can lose a lot of money very quickly when trying to trade FX.
And the odds are stacked against the average trader.
Around two-thirds of retail traders lose money. That means traders only have a 33% chance of success on average. Even this is not guaranteed.
How to choose a FX trader (if you decide to give it a go)
If you really want to get into FX trading, there are some things you should keep in mind when choosing who you trade with..
Firstly, only use a regulated broker. The FCA’s website has a list of those brokers registered with the regulator. The site also has a list of companies that are trading and not regulated. These should be avoided at all costs.
Secondly, never trade with more than you can afford to lose. It’s likely you’ll lose all of your money so go into FX trading prepared for the worst.
Third, just because you’re offered leverage it doesn't mean you should use it.
Fourth, it’s imperative that you know what you’re doing. The FX trading market is awash with scams and bad actors, that’s without taking into account the risks of trading with borrowed money in the first place.